Look: I am eager to learn stuff I don't know--which requires actively courting and posting smart disagreement.

But as you will understand, I don't like to post things that mischaracterize and are aimed to mislead.

-- Brad Delong

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Sunday, June 19, 2011

Low Interest Rates and the Rentier Class

I borrowed the title from Philipji, where commenting is not enabled.

Philip, it seems, is an iconoclast who apparently thinks that all theories of economics are wrong.  In principle, I cannot disagree.  This however does not make Philip right.

In the subject post, Philip shows the graph of labor's share of nonfarm business income that Thoma and Frum had recently displayed.  He also shows a graph of the Federal Funds rate, a topic in which I have some interest.   Even an old man in bifocals can see the two lines falling, though not in lock-step.  These are similarly moving secular trends.   He sees cause and effect, and his argument makes sense.

Actually the explanation is quite simple. The entities who really benefit from low interest rates are hedge funds and traders of financial instruments. Typically, they take advantage of mispricings of securities amounting to a few cents. And how do they parlay such tiny mispricings into incomes amounting to tens and hundreds of millions of dollars? By leveraging their equity ten, fifty or a hundred times. And of course they can do that only if money is dirt-cheap. 

Equally important, this hurts the producers of real goods and services who are looking for loans. At present the prime rate is around 3.25%. What self-respecting bank would lend at 5% or even 10% and wait a whole year when they can earn more in just a few weeks by trading in financial instruments? If nothing else, the bonuses currently being paid to bankers should make this obvious -- to all but those rendered blind by ideology.

Again, I do not disagree.  But there is a lot he leaves out.   First, he assumes (I assume) that interest rates are determined by the Fed.   As my post (linked above) indicates, empirical evidence suggests otherwise.  Secondly, he sees low rates as the root cause, where it is really only an enabler.

In my view, the root causes are low taxation and lax regulation.   As I've stated before, futures markets serve a vital function.  The same might also be true of other financial instruments, such as options, but I haven't thought it through and my gut feeling is negative.

If I'm right about root causes, then solutions are obvious: not high interest rates which will hurt everyone who is struggling, but tax and regulation aimed at curtailing the rentiers.   Others have suggested a small transaction tax that will reduce the small gains.  I concur, and also recommend severely limited margin to minimize the effects of leverage, and minimum holding periods, in the range of hours, days, or weeks to eliminate the opportunity to have a dedicated computer respond to momentary imbalances.

To summarize, low interest rates aren't the problem.  They are a symptom of the current economic malaise.  The solution set does not include interest rate hikes, which would send the economy into even more of a tail spin.

While I appreciate Philip's chutzpah  and original thinking, his thinking on this issue stops at the surface.

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